SKOKIE, Ill. – The U.S. economy is set to move into high gear in 2004 according to the latest economic forecast from the Portland Cement Association. The optimistic outlook arrives courtesy of recent improvements in U.S. labor markets; however, PCA does not expect robust construction activity to arrive until 2005.

Chief economist Edward Sullivan explains, “The seemingly contradictory outlook is based on the prospects of cooling single-family construction under the weight of rising interest rates, a delayed and muted improvement in commercial construction activity, and a public construction sector still coping with state-level fiscal crises.”

PCA reports the emerging economic recovery will create jobs, escalate wage gains, and lead to stronger capital gains. Combined, these factors will strengthen states’ tax base, resulting in a gradual easing of fiscal stress. PCA projects 2.7 to 3.0 percent growth in cement consumption for 2005-2008.

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Residential Construction Outlook
Nonresidential Construction Outlook
Public Construction Outlook

Long-Term Replete with Optimism

Optimism, absent from the U.S. economic outlook for some time, is now permeating nearly every corner of the economic spectrum. This spirit of optimism arrived on the scene only recently with improvements in the U.S. labor market. However, there remain skeptics whose thinking is still colored by prolonged anemic growth conditions that endured from the fourth quarter of 2000 until the second quarter of 2003 (with economic growth averaging a meager 1.9%).

Fortunately, those days are behind. The economy is poised for a sustained period of relatively robust conditions, with real GDP growth to average between 3.5 to 4.0% annually.

Consumer Spending
Until recently, consumers have carried the economy on their shoulders, achieving a sustained pattern of growth while each of the other key sectors of the economy succumbed to decline.

Much of the strength in consumer spending has been enabled by extremely low mortgage rates allowing homeowners to tap into home equity reserves. Indeed, 80% of mortgage activity during most of 2003 is attributed to refinancing rather than new originations. All totaled, cash out from home refinancing will add nearly $150 billion to consumer spending during 2003.

Debt financing of consumer spending caused concern that the strategy could not be sustained for a prolonged period in an era of mounting job losses. Indeed, stress points materialized in the form of high consumer debt burdens, rising personal bankruptcies, increases in home foreclosures, and accelerating delinquency rates. Fortunately, evidence suggests that the generation of new jobs has reversed these alarming trends. Arguably, the job market turned the corner in August, adding an average of 125,000 new jobs each month during the fourth quarter of 2003.

Going forward, consumer spending activity will be increasingly fueled by traditional sources of strength – namely rising income and job growth. This transition is important since interest rates are expected to rise by mid-2004 – diminishing the positive impact of tapping home equity to fund consumer purchases.

Business Sentiment
While consumer spending strength is expected to continue throughout 2004, it alone is not enough to insure robust economic growth. There has been dramatic recovery in business confidence since the end to major combat in Iraq – increasing four-fold, according to various surveys.

This recovery in business confidence was a necessary precursor to a recovery in business investment activity. An improvement in corporate profits coupled with more favorable bank lending conditions has created an environment for businesses to release pent-up demand for investment goods.

Investment spending surged in the third quarter and is expected to continue growing at a relatively strong pace throughout 2004. It is the partnership of sustained consumer spending growth and the emergence of an investment spending recovery that is the basis for such optimism regarding the near-term economic future.

Interest Rate Outlook Changes Economic Landscape

Most economists accept the notion that stronger economic growth conditions will bring forth higher interest rates during 2004. However, the key question is when will rates increase?

As the economy recovers, increased demand on U.S. capital markets will materialize, resulting in sustained upward pressure on interest rates throughout 2004 and beyond. This source of pressure on interest rates is expected to result in creeping increases and is not considered a major near-term source for rising rates.

More importantly, the strengthening economic demand picture supports continued acceleration in the job market and unfortunately, stronger inflationary pressures. Inflation has been dormant for such a long time, it is difficult for some to accept the notion that price pressures will accelerate.

While not evident yet at the consumer level, there are already signs that inflation is heating up. As inflation pressures gain traction, the Federal Reserve will be forced to adopt a tighter monetary policy and raise interest rates. Actions by the Federal Reserve are expected to provide the main thrust in rising rates. Significantly higher inflation rates will be averted with the raising of interest rates.

From PCA’s viewpoint, the real issue with regard to near-term interest rates is not the directional movement of interest rates but the timing of rate hikes. The timing assumptions contained in PCA’s economic forecast could make considerable differences in the level and composition of construction activity and therefore, cement consumption.

Quick and strong action by the Federal Reserve will result in considerable erosion in residential construction, slow the pace of nonresidential construction’s recovery, and prolong the dismal fiscal crisis still gripping state governments. According to this timing, the strengthening of economic growth and construction activity is subdued.

In contrast, a delayed and relatively passive reaction by the Federal Reserve suggests a continuation of strong residential construction activity as well as faster economic growth – accelerating the timing of recoveries in nonresidential and state construction activity. While this may seem an attractive scenario, inflation could ramp-up considerably and lead to a harsh correction by the Federal Reserve in 2005.

Quite frankly, the timing assumptions regarding Federal Reserve action in earlier PCA outlook scenarios was a source of forecasting error. PCA’s forecast pegs Federal Reserve actions to improvements in the labor markets. The time period between an improvement in labor markets and the resulting policy reversal by the Federal Reserve to raise rates is referred to as the gestation period. PCA identified four periods during the 1970-1990 period in which the Federal Reserve engaged in policy reversals – moving from an easing or neutral stance to a policy of monetary tightening.

A short gestation period materialized in every recovery with the exception of the 1990 recovery. In PCA’s recent forecasts, a strict numerical average was employed, leading to the incorrect conclusion and assumption of quick Federal Reserve action.

The resulting impact of our interest rate assessments on construction activity and cement consumption are fairly obvious. In the context of Federal Reserve inaction to raise rates, mortgage rates did not reach the levels anticipated – causing PCA to underestimate strength in residential housing construction and cement consumption originating from this sector.

Keep in mind, the strength in single family housing starts far exceeded estimates even under a low interest rate scenario. Nevertheless, it has been the spectacular performance in this sector that will lead to a small gain in overall cement consumption during 2003.

In hindsight, it is clear that the conditions surrounding the current recovery period are more similar to those experienced in 1990 than the statistical 20-year average. As a result, PCA has stretched its Federal Reserve gestation period and now reflects one closer to that experienced in 1990. The current forecast now reflects a seven-month gestation period, implying a rise in rates by mid-2004. According to PCA’s forecast scenario, rates are increased initially by 25 basis points late in the second quarter. These rate hikes are followed by periodic 50 basis point increases through 2004 and beyond.

Residential Construction Outlook

The residential sector accounts for roughly 25% of overall construction activity and is comprised of single-family construction, multifamily construction, and home improvements. This sector, despite its relative size, has been raging during the past two years and is responsible for providing essential support to the construction industry and overall economy during the past two years.

Single-Family Construction
While single-family construction will remain at historically strong levels, the economic conditions that are expected to materialize by mid-2004 are adverse. Mortgage rates will begin a sustained ascent beginning late in the second quarter. The increase will adversely affect homebuyer affordability. However, it is important to note that housing starts will remain near record levels during the first half of 2004.

Furthermore, adverse consumer affordability issues are not overwhelming – they are just strong enough to take the edge off the extremely strong market conditions that currently prevail and induce a modest decline in building starts and single-family construction spending.

Without a more rapid increase in interest rates than currently anticipated, a single-family housing bust is not in the cards. Indeed, in some key cement consuming states such as California, Texas and Florida, extremely favorable population and demographic conditions will soften the declines in single-family activity.

Multifamily Construction
Multi-family construction activity has been adversely impacted by the low mortgage rate environment. Low interest rates have decreased the spread between the average monthly mortgage payment and average monthly rent. In 2000, the average monthly mortgage payment was roughly twice that of the average rent. By mid-2003 the mortgage payment premium was only 25%. This measure does not take into consideration the tax benefits of home ownership.

As monthly payments approached parity, more and more apartment dwellers were able to become homeowners – resulting in rising apartment vacancy rates. As vacancy rates moved upward, landlord discounts and a general easing in rental prices materialized, translating into a dismal picture for multifamily investors. Unfortunately, the current adverse conditions are not going to change anytime soon.

The 9.6% average apartment vacancy rate will probably worsen before it gets better. Even as interest rates climb and keep more potential first-time homebuyers in apartments, it will take the better part of a year before vacancies decline to a level prompting acceleration in multi-family construction activity. Nonetheless, the revival in multi-family construction is expected to be very modest.

Nonresidential Construction Outlook

Nonresidential construction accounts for roughly 25% of overall construction activity. Soft economic conditions have resulted in dismal performances by the sector’s three largest players - industrial, office and retail construction activity.

Among these sectors the anemic performance of the economy has resulted in low industrial capacity utilization rates as well as rising office and retail vacancy rates – diminishing the need for new investment. At the same time, the soft economic conditions punished corporate profitability and created a harsh lending environment – diminishing the ability for new investment.

With the exception of retail construction, one or two quarters of favorable economic news is not going to favorably turn the conditions facing the office and industrial sectors. It typically takes a year before industrial construction activity turns positive. If this trend holds, it implies a 2004 recovery for industrial construction. In the meantime, industrial construction activity will continue to record negative growth, albeit at more moderate rates than encountered during 2003.

The lag between an improvement in office vacancy rates and improved office construction activity is only slightly longer. Unfortunately, vacancy rates have yet to turn, implying that the recovery process for office construction has yet to begin. While a turnaround is possible in late 2004, the odds on an early 2005 turn are increasing. Similar to the conditions in the industrial sector, office construction activity will record negative growth for most 2004, albeit at moderated rates of decline.

Unlike industrial and office building construction activity, retail construction has a short lag between improved economic conditions and a turn in retail construction. Indeed, retail construction activity has already turned. Retail construction is expected to grow at a rate of more than 5% during 2004. Retail construction activity is slightly larger than the office and industrial sectors combined. As a result, the positive contribution to nonresidential originating from this sector is expected to more than offset marginal weakness in the office and industrial sectors – leading to a small net gain in overall nonresidential construction for 2004.

Public Construction Outlook

While public construction accounts for roughly 25% of total construction activity, it accounts for half of all cement consumption. Furthermore, it is important to recognize that more than 90% of public sector construction activity is carried out by the state and local governments. As a result, the fiscal conditions of state governments, largely dictate their ability to carry out construction activity. The sustained period of anemic economic growth has caused historic budget deficits at the state level.

State Fiscal Crisis
State deficits typically arise during times of recession or severe growth slowdowns. Generally, the deficits reflect a slowdown in revenue growth in the context of sustained state spending patterns. In the past, most state governments could run deficits until stronger revenue growth materialized with the onset of economic recovery. Under such conditions, the adverse impact of a deficit on state expenditure patterns and construction activity were buffered to a certain extent.

However, the current state fiscal crisis has important differences. Unlike the past conditions that gave rise to deficits, most state governments now enforce a balance budget amendment – requiring immediate revenue or expenditure responses by the state government to correct deficits. Balanced budget amendments increase the exposure of cutbacks in state construction activity, compared to past deficit conditions.

Furthermore, the prolonged period of robust growth in state revenue collections during 1995-2000 created a mindset among state budget officers that the financing for new projects was endless. Spending excesses, combined with the revenue softening has resulted in an unparalleled magnitude of deficits. Furthermore, the deficit crisis is pervasive throughout the United States.

To cope with their deficits, states cut extraneous programs, laid off workers, raised taxes, and, as a last resort, cut capital construction expenditure programs. It is important to note that many states believed that construction spending provided stimulus to local economic activity and were hesitant to cut these programs. As the deficit issue worsened in 2002, even these programs were cut in many states and adversely impacted overall 2003 public construction activity.

A glimmer of optimism is beginning to emerge regarding future state fiscal conditions. Entering 2003, 45 states faced deficits at an estimated $60 billion in red ink. In late spring 2003, stronger national economic recovery began to emerge. The potential for job growth and income gains provided the prospect of stronger state revenue flows. This, coupled with the cost-cutting and tax increases, reduced the prospect of year-forward state deficit projections to $20 billion.

According to PCA’s analysis, the general improvement in labor markets during 2004-2007 will lead to a recovery in state revenues by adding workers and increasing average wages – both adding to the tax base. The improvement in state revenue conditions beginning in 2004 will set the table for improved expenditures in 2005. The logic behind this one year lag is our assumption that state officials will not commit to new capital programs until it is perceived that a sustained revenue increase, determined by a year-long upturn in revenues, is imminent.

Not all states will share in the improvement in state revenue and spending growth according to the same timetable. States with massive deficits will suffer through a prolonged period of correction - hostile to an improvement in state spending.

Unfortunately, there is a year lag between improvement in the revenue outlook facing states and resulting expenditure improvements. In essence, 2004 budgets have been cast in the light of rather dire revenue projections due to the overall economic weakness encountered during the first half of 2003. As a result, little reprieve from Spartan state construction spending programs is expected to materialize during 2004.

Fortunately, recent job and income gains are expected to be sustained throughout 2004 – leading to higher revenue projections for the 2005 budget.

Assessments made regarding state fiscal conditions play a huge role in determining public construction activity. Due to the importance of public spending on overall cement consumption, alternative assumptions regarding the recovery in state finances may result in substantially different future cement consumption estimates.

Highway Construction
Troubling state fiscal conditions will continue to place stress on discretionary state highway spending during the near term. This, coupled with the lack of a reauthorization of TEA-21, will continue to cast a cloud over highway construction during 2004 – with flat to small declines anticipated.

Not all highway and street state expenditures are tied to TEA. These non-TEA expenditures are more closely tied to the fiscal condition of the state, referred to as “discretionary highway and street state expenditures.” Discretionary spending is calculated as the difference between total state highway expenditures and the estimated TEA apportionment for each state.

According to PCA’s methodology, the more severe a particular state’s fiscal condition the greater the moderation in overall state expenditures and discretionary state highway spending. Discretionary highway and streets spending for states under financial duress, such as California, will be adversely affected.

As state revenue conditions improve, state discretionary highway spending will improve as well. By 2005, PCA expects the beginning of improvement in discretionary highway spending to materialize in 2006-2007. Increased spending is expected to be supplemented by larger TEA funding levels.

TEA Assumptions
Based upon discussions with various experts, there are considerable differences in opinion regarding the political outcome for new national TEA funding levels. Rather than bet the bank on a political assessment, PCA Economics has opted to employ the average of the Bush Plan and the Senate Plan. In doing so, the political risk associated with our projections is theoretically minimized. PCA has adopted one modification to a strict average. Given the late date and no clear political solution on the horizon, PCA has taken the Senate’s Plan levels and pushed it back one year – making 2004 planned levels the 2005 estimates used in our calculations.

Federal legislation aimed at national transportation, is expected to be renewed for the 2005 fiscal year. At worst, the Bush plan will be implemented – resulting in a 17% increase in funds directed at national transportation construction. The House and Senate each have progressively more generous proposals that embrace 2005-2010. While these proposals suggest strong public sector construction in 2005 and beyond – congressional delays and inaction on these programs have doomed the prospects of a significant federal stimulus for 2004.

Summary

The composition of construction growth is on the verge of change. In past years, residential activity has been the principal source of strength in the construction market. Growth in public construction activity has been under fiscal stress and nonresidential has suffered as a result of anemic overall economic growth conditions. Moving forward, PCA expects nonresidential and public spending construction activity will increasingly become the growth leaders – with residential construction recording negative growth.

The improving economy is expected to bring rising interest rates, which will result in a sustained and gradual erosion of single family starts activity beginning in the second half of 2004. At the same time, improving economic conditions will increasingly drive the recovery in nonresidential activity. The recovery in nonresidential construction is expected to be led by other commercial activity. Long lag times between improvement in economic conditions and improvement in office and industrial construction activity imply that those sectors will not begin to turn until late 2004 or early 2005.

The emerging economic recovery will create jobs, escalate wage gains, and lead to stronger capital gains. Combined, these factors will strengthen states’ tax base resulting in a gradual easing of fiscal stress. While this improvement will do little to help 2004 state construction spending, it will offer hope for 2005.

PCA’s outlook for 2004 construction calls for cautious optimism reflected in our forecast of sub 1% growth in cement consumption. Recent economic reports show a strengthening pattern in excess of PCA’s baseline. This implies the possibility of upside risk to PCA projections. Furthermore, it is important to note that key factors of cement demand seem to be converging – leading to stronger growth in cement consumption during 2005-2007.

During this period, even though single-family construction will face sustained declines, they will reflect strength when measured from a historical perspective. In addition, all facets of nonresidential activity are expected to post positive growth. Finally, the fiscal crisis in most states will have passed – permitting stronger gains in public construction activity. These gains will presumably be supplemented by significantly higher TEA funding.

All totaled, it is difficult to construct a scenario during the 2005-2008 period that does not reflect rather strong gains in cement consumption. Indeed, our projections calling for 2.7% to 3.0% growth in cement consumption during this period contain significant upside risk.

About the Portland Cement Association

Based in Skokie, Ill., the Portland Cement Association represents cement companies in the United States and Canada. It conducts market development, engineering, research, education, and public affairs programs.

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